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					Chapter 11 - Accounts Receivable, Notes Receivable, and Revenue


                             Accounts Receivable,
                             Notes Receivable, and

Review Questions

11-1    The term "customer's order" refers to the purchase order received from a customer. The term
        "sales order" refers to the document created upon receipt of a customer's order. The sales order
        is a translation of the terms of the customer's order into a set of specific instructions for the
        guidance of various departments, including the credit department, finished goods, stores,
        shipping, billing, and accounts receivable.

11-2    The audit of revenue and receivables is of significant audit risk because (1) overstatement of
        revenue has been a factor in many instances of fraudulent financial reporting, (2) the
        overstatement of revenue results in a corresponding overstatement of net income, (3) the
        determination of the amount of revenue recognized may be determined by the application of
        complex accounting principles, and (4) significant accounting estimates may be involve in the
        determination of the financial statement presentation of receivables and revenue.

11-3    Good internal control in the billing process requires that someone other than the employee
        preparing the invoice shall review the accuracy of prices, credit terms, and other data on the
        invoice before this document is released.

11-4    The objective of the billing process is to notify the customer of the amount due for goods or
        services delivered. A most important document created by the billing department is the sales
        invoice. The original is sent to the customer, and copies are used to record accounts receivable
        and sales.

11-5    The statement is incorrect. Credit memoranda are used to credit (reduce) accounts receivable
        when goods sold on credit are being returned, or when a defect in the goods justifies a price
        reduction. Credit memoranda are not issued to remove uncollectible accounts receivable from
        the records. Such write-off of worthless receivables is handled by a general journal entry
        debiting the Allowance for Doubtful Accounts and crediting Accounts Receivable.

Chapter 11 - Accounts Receivable, Notes Receivable, and Revenue

11-6    The sales invoices (and the shipping documents as well) should be serially numbered. When
        each day's invoices are transmitted from the billing department to the accounts receivable
        department, they should be accompanied by a transmittal list showing the serial numbers of all
        sales invoices. Every number in the series should be accounted for. If a computer is used to
        record sales invoices item counts and control totals should be used to ensure that all sales are

11-7    The statement is correct in suggesting that voided shipping documents should be cancelled.
        However, they should be retained, and not discarded so as to assure that the numerical
        sequence may be accounted for.

11-8    All sales invoices should be serially numbered. Each day the billing department should send
        copies of the invoices prepared that day to the accounts receivable department accompanied by
        a transmittal letter specifying the invoice numbers used and the total dollar amount billed. By
        comparing the individual invoices with the list of serial numbers and comparing the total debits
        to accounts receivable with the total figure for billings, the accounts receivable department can
        be sure that it has received and recorded all sales invoices.

11-9    Other specific procedures which contribute to good internal control over the business processes
        related to accounts receivable include (only three required):

        (1)     The separation of the duties of the accounts receivable accountant from all cash
                handling functions.

        (2)     Regular balancing of the subsidiary ledger of receivables with the general ledger
                control account by an employee other than the accounts receivable accountant.

        (3)     Regular aging of accounts receivable and review by management.

        (4)     Periodic review of delinquent accounts by an appropriate executive.

        (5)     Periodic confirmation of accounts receivable by internal auditors.

        (6)     Serial numbering of shipping documents, sales invoices, and credit memoranda, and
                regular accounting for all numbers in the series.

11-10 The auditors should confirm with the bank the loss contingency for notes receivable
      discounted. The auditors also should send separate confirmation requests to the makers of the
      notes receivable which were discounted to determine the genuineness and validity of the notes.

11-11 The write-off of small notes receivable from officers, directors, stockholders, or affiliated
      companies is obviously irregular and unacceptable practice. Such notes are almost always
      collectible by virtue of the positions held by the makers. The auditors should investigate these
      related party transactions fully; they will probably find that the charges to the allowance for
      uncollectible notes were made in error and were not authorized by management. If the amounts
      were large, there would be more reason to suspect an intention of self-serving activities or fraud
      on the part of the management.

11-12 Among the audit procedures commonly applied to notes receivable but not to accounts
      receivable are the following:

Chapter 11 - Accounts Receivable, Notes Receivable, and Revenue

        (1)     Verification of interest earned and accrued interest receivable.

        (2)     Examination of the note.

11-13 The client company should request (on its letterhead) the customer to confirm the account
      receivable. The auditors have no authority to make such a request directly on their stationery.
      The return envelope should be addressed to the auditors' office to assure that the auditors have
      control over confirmation returns.

11-14 The audit objective of determining the existence of receivables is most directly addressed by
      the audit procedure of confirming accounts receivable and notes receivable by direct
      communication with debtors. In addition, written confirmation also addresses the completeness
      and valuation assertions, but less effectively because it deals only with recorded accounts and
      provides limited information on whether the receivable is collectible. The procedure also
      provides evidence of occurrence and accuracy of revenue transactions.

11-15 If the auditors find post office box addresses for many individual customers whose accounts
      were selected for confirmation, the auditors should consider the possibility that the customers
      may be fictitious, and that dishonest employees of the client company plan to "answer" the
      confirmation requests.

11-16 Alternative auditing procedures to verify accounts receivable when confirmation is not
      practicable or possible include examination of customers' purchase orders or contracts;
      examination of client's duplicate shipping documents and invoices; and review of payments
      received from customers subsequent to the balance sheet date.

11-17 Alternate auditing procedures that may be used when customers have not replied to
      confirmation requests include:

        (1)     Send additional requests by registered or certified mail, with return receipt requested.

        (2)     The auditors might telephone to ascertain the balance or the reason for failure to
                respond to the written request.

        (3)     Under some circumstances, requests may be made by fax machine.

        (4)     The auditors may examine any payments to the account made subsequent to the
                balance sheet date. The auditors may also examine the duplicate invoices, shipping
                records, purchase orders, etc., for transactions making up the unpaid balance.

11-18 To test the client's sales cutoff at June 30, the auditors should compare shipping records with
      entries in the sales journal, and receiving records with entries recording sales returns, for
      several days prior to and subsequent to June 30. The auditors will be alert for sales and sales
      returns recorded in the wrong accounting period.

Chapter 11 - Accounts Receivable, Notes Receivable, and Revenue

11-19 An unusually large number of sales transactions just prior to the balance sheet date should be
      fully investigated by the auditors. This situation may result from a strenuous effort made
      during the closing days of the period to get out shipments and meet a sales quota. On the other
      hand, it may reflect an improper cutoff of sales transactions at year-end, or even the recording
      of fictitious sales. In any event, the auditors' investigation should include matching of sales
      invoices with shipping documents and customers' orders, and discussions with executives.
      Careful analysis of sales returns during the succeeding period may also shed light on the

11-20 Excessive sales returns or allowances may indicate shipments made without customers' orders,
      shipments of defective merchandise, a misstatement of inventory or of sales and receivables, or
      weaknesses in internal control. One purpose of a review of sales returns and allowances
      subsequent to the balance sheet date is to uncover any facts which necessitate adjustment of
      inventories, receivables, or sales in the statements being audited. Another purpose is to test
      internal control effectiveness.

11-21 The credit memoranda should bear the date and serial number of the receiving report on the
      return shipment. The credit memoranda selected by the auditors for testing can be compared
      with records of the receiving department to determine that goods were actually returned.

11-22 In testing the adequacy of the client company's allowance for doubtful accounts receivable, the
      auditors review the following:

        (1)     Large past-due accounts not paid subsequent to the audit date.

        (2)     An aged trial balance of accounts receivable and comparison with those of prior years.

        (3)     Accounts in dispute as evidenced by confirmation exceptions or by correspondence in
                the client's files.

        (4)     Unfavorable reports of collection prospects on accounts assigned to collection agencies
                or attorneys.

        (5)     Opinions of the client's credit manager as to the collectible portion of each large past-
                due account.

        (6)     Relationship of the valuation allowance to (a) accounts receivable, (b) net credit sales,
                and (c) accounts written off during the year. These ratios should be compared with
                those prevailing in past years and industry averages.

        (7)     Information from a retrospective review of prior year’s allowance that indicates
                whether management might bias its estimates.

11-23 Examples of types of receivables originating without arm's-length bargaining include loans to
      insiders (directors, officers, key employees) and loans to affiliated companies. These types of
      receivables should be shown separately with disclosure of the nature of the relationships and
      the amounts of the transactions.

Chapter 11 - Accounts Receivable, Notes Receivable, and Revenue

11-24 As required by SAS No. 99 a retrospective review is an analysis of the judgments and
      assumptions underlying a prior year accounting estimate. With hindsight the auditors can
      evaluate whether there appears to be any management bias in the prior year estimate. The
      purpose with respect to revenue is to provide information about possible management bias to
      assist in the audit of the current year revenue estimates.

Questions Requiring Analysis

11-25 (a)       According the SEC Staff Accounting Bulletin No. 104 the following criteria must be
                met for revenue to be recognized:

                    Persuasive evidence of an arrangement (contract) exists,
                    Delivery has occurred or services have been rendered,
                    The seller’s price to the buyer is fixed or determinable, and
                    Collectibility is reasonably assured.

        (b)     To overstate revenue the following techniques might be used by Processing Solutions’
                management (only two required):

                1. Recording of fictitious contracts with customers.
                2. Recording revenue before a contract is executed.
                3. Recording revenue when the company has entered into side agreements with the
                   customers that affect the realization of revenue (e.g., allowing liberal return
                4. Allocating excessive amounts of revenue to the delivery and set-up of the system to
                   recognized revenue early.

Chapter 11 - Accounts Receivable, Notes Receivable, and Revenue

              Overstatement Technique                        Audit Procedure
              1. Recording of fictitious contracts with       Confirmation of contracts with
                 customers.                                     customers. Inquiries of salespeople about
                                                              Confirmation of contract terms with

              2. Recording revenue before a contract is          Inquiries of salespeople about contract
                 executed.                                        execution dates.

              3. Recording revenue when the company              Confirmation of contract terms with
                 has entered into side agreements with            customers, including the existence of any
                 the customers that affect the                    side agreements.
                 recognition of revenue (e.g., allowing          Inquiries of salespeople about oral
                 liberal return privileges).                      modification of contract terms and side

              4. Allocating excessive amounts of                 Review of allocation of contract revenue
                 revenue to the delivery and set-up of            to the multiple elements of the contract,
                 the system to recognize revenue early.           e.g., software, setup, maintenance, etc.
                                                                  Revenue should be recognized on the
                                                                  elements based on their relative fair
                                                                  market values.

11-26 (a)        When a company engages in bill and hold transactions there is a possibility that the
                 company is inappropriately recognizing revenue. The auditors must ascertain that any
                 transactions recognized as sales meet the criteria for revenue recognition as set forth in
                 SEC Accounting and Auditing Enforcement Release No. 108. In these circumstances,
                 the auditors will review the provisions of sales contracts and consider confirming the
                 terms with customers.

        (b)      When a company sells using a multiple element arrangement, the revenue must be
                 allocated to the elements in relation to their fair values. Therefore, there is a possibility
                 that management may attempted to misstate revenue by inappropriate allocation. In
                 these situations, the auditors will review the sales contracts and evaluate the
                 reasonableness of management’s allocation of the revenue to the various elements.

        (c)      When a company uses the percentage-of-completion method, there is a risk that
                 management may misestimate the amount of revenue earned on uncompleted contracts.
                  The auditors must carefully evaluate the costs allocated to the contracts and the
                 estimates of the percentage-of-completion. In some cases, the auditors may decide to
                 engage a specialist, such as an engineer.

Chapter 11 - Accounts Receivable, Notes Receivable, and Revenue

        (d)     When a company’s sales agreements allow for returns, there is a risk that management
                misstate the estimate of sales returns and, therefore, misstate revenue and receivables.
                In these situations, the auditors should carefully review the contracts to determine that
                revenue should be recognized at the time of sale. If revenue recognition is appropriate,
                they should next evaluate the adequacy of management’s estimate of sales returns.

11-27 (a) Sales invoice; (b) approved sales order; (c) customer’s purchase order; (d) approved sales
      order; (e) sales invoice.

11-28 All three generally accepted auditing standards of field work were violated in the audit of the
      accounts receivable of Thorne Company. The first standard of field work, which requires
      adequate planning of the audit and proper supervision of assistants, was obviously violated.
      Planning was inadequate because no audit plan, audit programs, or time budgets were prepared.
       Supervision was inadequate because Martin Joseph, an inexperienced staff assistant, was left
      on his own to audit the accounts receivable, with no guidance from the senior auditor.
             The second standard of field work, which requires the auditors to obtain an
      understanding of the entity and its environment, including existing internal control, was
      violated. Martin Joseph did not obtain an understanding of the internal control for the business
      processes related to accounts receivable, nor did he perform tests of controls over receivables
      and sales transactions. Obviously, the substantive procedures that Joseph applied to Thorne
      Company’s accounts receivable were merely a repetition of the preceding year’s audit
             The third standard of field work, which requires the obtaining of sufficient competent
      evidence matter, was violated because no assessments of the risks of material misstatement
      were performed. What constitutes sufficient, competent evidence in an audit is determined
      principally by the assessed levels of risks of material misstatement (inherent and control risks).

11-29 (a)       An audit confirmation request is a written communication received by the auditors
                directly from a party outside the client organization. The written communication
                usually affirms the existence of, and rights to, an amount recorded in the client’s
                accounting records.

        (b)     To be valid evidence, an audit confirmation response must be received directly by the
                CPA firm from the outside party who has replied to the confirmation request.

        (c)     A positive confirmation request requires a reply from the client’s customer in every
                case. A negative confirmation request requires a reply only if the balance for which
                confirmation has been requested is incorrect.

        (d)     Negative confirmation requests may be used for situations in which (1) the combined
                assessed level of inherent and control risk is low; (b) a large number of small balances
                is involved; and (c) the auditors have no reason to believe that the recipients of the
                requests are not likely to give them consideration.

11-30 The confirmation requests should go to the makers of the notes regardless of whether the notes
      have been discounted. The act of discounting a note receivable does not reduce the importance
      of the note being genuine and collectible. A company which discounts its notes receivable
      remains in a position of sustaining a loss if the makers of the notes fail to make payment at the
      maturity dates.

Chapter 11 - Accounts Receivable, Notes Receivable, and Revenue

11-31 (a)       There are two forms of confirmation requests for accounts receivable: the “positive”
                form and the “negative” form.
                       The positive form asks the debtor to respond whether or not the debtor is in
                agreement with the information on the confirmation request. A negative form asks the
                debtor to respond only if the debtor disagrees with the information shown on the
                confirmation request or monthly statement.
                       The use of the positive form is preferable when individual account balances are
                relatively large, when there is reason to believe that there may be a substantial number
                of accounts in dispute, or with inaccuracies or fraud.
                       The negative form is useful when internal control surrounding accounts
                receivable is considered to be effective, and a large number of small balances is
                involved, and the auditor has no reason to believe that persons receiving the requests
                are unlikely to give them consideration.

        (b)     A debtor’s acknowledgement of indebtedness does not indicate whether the receivable
                is collectible. A good indicator of collectibility is an aging schedule. Generally the
                older an account is, the less likely it will be collected.
                       Jones should review, analyze, and interpret the aging schedule to determine
                whether the client’s allowance for doubtful accounts is adequate. If not, an adjustment
                by the client should be recommended.
                       In connection with the review and interpretation of the aging schedule, Jones
                should investigate accounts receivable losses of preceding periods and any
                uncollectible accounts charged off in the current period to determine if the bad debt
                rate is increasing, and if charge-offs because of uncollectibility are properly approved.
                After a review of correspondence, minutes, and collection procedures with the
                appropriate officials in the client’s credit and collection department, Jones should
                prepare an estimate of the probable collection losses and compare the estimate to the
                amount of the recorded allowance. If necessary, Jones should review client credit files
                as well as reports of external credit agencies. Jones also should examine subsequent
                cash receipts to ascertain what portion of amounts owing at the balance sheet date have
                been collected in the subsequent period.

11-32 Confirmation of accounts receivable by direct communication with debtors is usually essential
      to the issuance of an unqualified audit report. Confirmation of receivables is a presumed
      procedure, and failure to perform such a procedure when issuing an unqualified report requires
      justification in the working papers. The auditors must generally disclaim an opinion on the
      client’s financial statements when they have been forbidden by the client to confirm

11-33 (a)       When confirmation requests are mailed to debtors whose accounts were written off as
                uncollectible, the auditors’ purposes are to determine that the receivables were genuine
                when they were first recorded in the accounts and to determine that the accounts were
                not collected and the proceeds stolen. In some fraud cases, fictitious accounts
                receivable have been created to cover up a shortage. Eventually these fictitious
                receivables must be disposed of; one method is to write off the fictitious accounts as
                uncollectible. In other cases, valid accounts receivable have been collected, but written
                off as uncollectible by the employee who has procured the funds.

Chapter 11 - Accounts Receivable, Notes Receivable, and Revenue

        (b)     The Solar executive appears to believe the auditors are solely concerned with the
                valuation or collectibility of accounts and notes receivable. In fact, the confirmation
                process is primarily intended to establish that the receivables are valid and that the
                customers (or makers of notes) exist. Other audit procedures are followed to determine
                proper valuation.

11-34 No. The matter remains unresolved. First, oral evidence from the client is seldom in itself
      sufficient; the auditors must follow up to determine the reliability of the oral evidence. Second,
      payment of an account receivable is not confirmation; the account might be fictitious, and the
      "payment" could have been made by a dishonest employee who had created the fictitious
      account to conceal a cash shortage. The auditors must examine the customer purchase order or
      contract, and copies of the sales invoice and shipping document in support of the unconfirmed
      receivable. They should may also determine the genuineness of the customer by reference to
      the telephone directory or to credit agency reports.

11-35 (a)       The items to be considered in determining the adequacy of the allowance for doubtful
                accounts are:

                (1)      Accounts that appear to be in dispute.
                (2)      Unusual variations in balances.
                (3)      Specific overdue accounts and deterioration of aged accounts.
                (4)      Levels of sales and write-offs.
                (5)      Historical cushion in the allowance.
                (6)      Cash collections affecting both the company and its customers.
                (7)      Economic conditions affecting both the company and its customers.
                (8)      Evidence of the customer’s inability to comply with credit terms.
                (9)      Unusual levels of returned products and product quality problems.

        (b)     To test the completeness of sales, the auditors determine how the company ensures that
                all shipments are invoiced and obtain evidence that the procedures operate as
                prescribed. Also obtain evidence from analytical procedures and cut-off tests.

11-36 Conn should consider applying the following additional substantive audit procedures:

         (1)    Test the accuracy of the aged accounts receivable schedule.
         (2)    Send second requests for all unanswered positive confirmation requests.
         (3)    Perform alternative auditing procedures for unanswered second confirmation requests.
         (4)    Reconcile and investigate exceptions reported on the confirmations.
         (5)    Project the results of the sample confirmation procedures to the population and
                evaluate the confirmation results.
         (6)    Determine whether any accounts receivable are owed by employees or related parties.
         (7)    Test the cutoff of sales, cash receipts, and sales returns and allowances.
         (8)    Evaluate the reasonableness of the allowance for doubtful accounts.
         (9)    Perform analytical procedures for accounts receivable (e.g., accounts receivable to
                credit sales, allowance for doubtful accounts to accounts receivable, sales to sales
                returns and allowances, doubtful accounts expense to net credit sales.)
        (10)    Review activity after the balance sheet date for unusual transactions.
        (11)    Determine that the presentation and disclosure of accounts receivable is in conformity
                with generally accepted accounting principles, consistently applied.

Chapter 11 - Accounts Receivable, Notes Receivable, and Revenue

11-37 In testing the aging of accounts indicated as past due, the assistant indeed verified the aging of
      those accounts. However, the assistant completely neglected the accounts indicated as current
      on the client-prepared trial balance. Any number of "current" accounts might in reality be past
      due. By ignoring a significant number of individual accounts, the assistant was deficient in the
      test and he had no basis whatsoever for reporting to the senior auditor that the client's aging
      work was satisfactory.

11-38 The answer to this question will vary with the nature of the company that the students select.
      However, almost universally these companies use the percentage-of-completion method for at
      least a portion of their revenues. This obviously presents the auditors with the risk that
      management’s estimates of cost to complete a project will not be reasonable, and revenue will
      be prematurely recognized.

11-39 (a)       When the auditors identify a risk as being significant and requiring special audit
                consideration, they must:

                (1)      Evaluate the design of the related controls and determine that they have been
                (2)      Not rely solely on analytical procedures to address the risk; and
                (3)      Not rely on evidence obtained from prior audits regarding the operating
                         of the related internal controls.

        (b)     Examples of ways that Nelson may react to this particular risk include (only one:

                (1)      Confirm the terms of sales contracts with selected customers.
                (2)      Examine a larger sample of sales contracts.
                (3)      Make expanded inquiries of sales personnel regarding the terms of contracts.

Multiple Choice Questions

11-40    (a)    (4)      Over-recorded sales due to a lack of control over the sales entry function
                         relates to control risk not inherent risk. The other three replies all relate to
                         inherent risk.

        (b)     (4)      Answer (4) is correct because receivables are valued at net realizable value,
                         and assessing the allowance for uncollectible accounts for reasonableness will
                         help the auditor determine the proper amount. Answer (1) is incorrect because
                         the limited information in the accounts receivable ledger will not make
                         possible tracing details to the shipping documents—also, the shipping
                         documents may not even capture the total sales price that is included in the
                         accounts receivable ledger. Answer (2) is incorrect because while comparing
                         turnover ratios may provide some information on the collectibility of
                         receivables, it is very imprecise. Answer (3) is incorrect because it relates to
                         presentation and disclosure more directly than valuation.

Chapter 11 - Accounts Receivable, Notes Receivable, and Revenue

        (c)     (4)      A sale either shouldn’t be recorded, or a proper allowance for returns should
                         be established when a customer is likely to return the goods. Thus, simply
                         recording the sale is an example of fraudulent financial reporting when the
                         customer is likely to record the goods. Answers (1) and (3) are examples of
                         errors, while answer (2) is an example of misappropriation of assets.
         (d)    (4)      Theft of cash register sales is an example of misappropriation of assets.
                         Answer (1) is an example of an error while answers (2) and (3) are examples
                         of fraudulent financial reporting.

        (e)     (1)      A presumption that receivables will be confirmed requires a combined
                         assessment of inherent risk and controls risk at the low level, immaterial
                         receivables, or circumstances in which the use of confirmations would be

        (f)     (2)      Answer (2) is not among the criteria because of the portion of the answer that
                         states “scheduled to occur in the near future.” Ordinarily delivery must have
                         occurred. Answers (2), (3) and (4) all describe circumstances required to
                         recognize revenue.

         (g)    (1)      The goal is to determine the population to be sampled from to determine that
                         all sales have been recorded; therefore, the sample should be taken from a
                         population of source documents, here the shipping documents file. None of
                         the other three answers represent source documents that may be sampled from
                         to determine that all sales have been recorded.

        (h)     (4)      Detecting overstated sales is a primary reason the auditors' review of a client's
                         sales cutoff. For example, shipments made in the first part of January may be
                         improperly included in the December sales total.

        (i)     (3)      The objective is to determine the population the auditors would sample from to
                         test the existence assertion for recorded receivables. The direction of testing
                         should be from the accounts receivable subsidiary ledger to the available
                         support, such as sales invoices, bills of lading, sales orders, and customers'

        (j)     (2)      Comparing shipping documents to related sales invoices addresses the
                         completeness assertion relating to sales. More specifically, it addresses
                         whether all items that have been shipped have been recorded as sales.

        (k)     (1)      The auditor would send positive confirmations rather than negative
                         confirmations because the fact that the balances are delinquent may indicate
                         that amounts are in dispute. Examining subsequent cash receipts, answer (3),
                         is unlikely to be effective since many of the accounts will not have been
                         collected. Inspection of internal records, answer (4), is likely to result in less
                         credibility evidential matter than confirming the accounts.

Chapter 11 - Accounts Receivable, Notes Receivable, and Revenue

        (l)     (1)      Write-offs of receivables should be approved by a responsible officer after a
                         review of the account by the credit department. Answer (2) is incorrect
                         because accounts receivable, a recordkeeping function, should not authorize
                         such entries. Answer (3) is incorrect because other procedures (e.g., a review
                         of shipping documents) may be used to determine that the goods were received
                         and because the shipping department would have no other information on
                         whether the receivable is likely to be collectible. Answer (4) is incorrect
                         because the account need not be overdue by several months as a "current"
                         receivable may become worthless due to, for example, a bankruptcy.


11-41 SOLUTION: Halston Toy Manufacturing Co. (Estimated time: 15 minutes)

        (a)     Due to the fact that Halston has a number of new products and a liberal return policy, it
                may be very difficult to estimate the allowance for sales returns. With new products it
                may be difficult to use prior return history to estimate the amount of returns.

        (b)     The auditors might consider performing the following procedures:

                (1)      Review any trade journals and industry data that might have information
                         relevant to sales of the new products.
                (2)      Review trends in sales returns in prior periods, especially when new products
                         were introduced.
                (3)      Make inquiries of sales personnel about customer feedback on sales of the new
                (4)      Review sales returns given in the subsequent period and compare the amounts
                         to prior periods.

11-42 SOLUTION: Internal Control, Tests of Controls, Substantive Procedures (Estimated time: 20

          (a)   (1)      Checking the clerical accuracy of invoices is a procedure that is designed to
                         improve the accuracy of customer billings and, therefore, the accuracy of sales
                         and accounts receivable.
                (2)      Accounting for prenumbered shipping documents is a procedure that is
                         designed to reduce the risk of unbilled shipments to customers. Thus, the
                         procedure serves to insure that all sales and accounts receivable are recorded.
                (3)      Approval of credit prior to shipment reduces the risk of sales to customers in
                         amounts in excess of their credit limits. The procedure helps to prevent
                         excessive credit losses.

          (b)   (1)      Clerical checking of invoices could be tested by examining a sample of sales
                         invoices processed throughout the year for indication (e.g., the checker's
                         initials) of performance of the procedure. Of course, the auditors should verify
                         the clerical accuracy of the sample invoices themselves to obtain evidence that
                         the checker effectively performed the procedure.

Chapter 11 - Accounts Receivable, Notes Receivable, and Revenue

                 (2)     Accounting for prenumbered shipping documents might be tested by
                         reviewing the numerical file of shipping documents (typically maintained in
                         the billing department) for missing items.
                 (3)     Adherence to credit approval procedures could be tested by examining the
                         documentation of a sample of transactions processed throughout the year,
                         noting that the credit approval date is before the date of shipment.

          (c)    (1)     Failing to check the clerical accuracy of sales invoices results in an increased
                         probability of errors in sales and accounts receivable. The auditors might
                         compensate by increasing the number of accounts receivable selected for
                         confirmation, or by shifting the confirmation date from an interim date to year-
                         end. Also, analytical procedures applied to the client's sales or gross margin
                         might provide evidence that sales are not materially misstated. For example,
                         monthly sales for the year under audit could be compared to forecasted
                         amounts, or similar amounts from prior years.
                 (2)     Lack of control over shipping documents may result in an understatement of
                         sales and accounts receivable. To test for this understatement the auditors
                         could select a sample of shipping documents processed during the year and
                         trace the details to a recorded sales transaction. Again, analytical procedures
                         for sales or gross margin percentages might provide an indication of whether
                         sales are understated by a material amount.
                 (3)     When credit approval is not obtained prior to shipment of goods, the amount of
                         uncollectible account expense as a percentage of sales is not likely to be as
                         stable. Thus, loss percentages of prior years are less useful in testing the
                         adequacy of the current year's allowance for doubtful accounts. To
                         compensate, the auditors might examine more credit information for specific
                         accounts, especially for those that are larger in amount or past due.

11-43 SOLUTION: Parktown Medical Center, Inc. (Estimated time: 25 minutes)

                        Weakness                                    Potential Misstatement

          1.    Employees who perform services are          Uncollectible accounts expense could be
                also permitted to approve credit            understated and accounts receivable could be
                without external credit check.              overstated because of the lack of an appropriate
                                                            credit check.

          2.    No independent verification of billing      Fees earned and accounts receivable may be
                process.                                    understated because not all services performed
                                                            might be reported for billing.

                                                            Fees earned and accounts receivable may be
                                                            either overstated or understated because of the
                                                            use of incorrect price or service data or because
                                                            of mathematical errors.

Chapter 11 - Accounts Receivable, Notes Receivable, and Revenue

          3.   The employees who approve credit also        Accounts receivable could be understated and
               approve write-offs of uncollectible          uncollectible accounts expense overstated
               accounts.                                    because write-offs of accounts receivable could
                                                            be approved for accounts that are, in fact,

                                                            Accounts receivable could be overstated and
                                                            uncollectible accounts expense understated
                                                            because write-offs of accounts receivable might
                                                            not be initiated for accounts that are

          4.   Credit is not granted on the basis of        Uncollectible accounts expense could be either
               established limits.                          understated or overstated because the lack of
                                                            established credit limits may make it more
                                                            difficult to identify uncollectible amounts.

          5.   The employee who initially handles           Fees earned and cash receipts or accounts
               cash receipts also prepares billings.        receivable could be understated because of
                                                            omitted or inaccurate billing.

          6.   The employee who makes bank                  The cash balance per books may be overstated
               deposits also reconciles bank                because not all cash is deposited.
                         Weakness                                    Potential Misstatement
          7.   Uncollectible accounts are not               Uncollectible accounts expense could be either
               determined on the basis of established       understated or overstated because of the lack of
               criteria.                                    established write-off criteria.

          8.   Trial balances of the accounts               Any of fees earned, cash receipts, and
               receivable subsidiary ledger are not         uncollectible accounts expense could be either
               prepared independently of, or verified       understated or overstated because of undetected
               and reconciled to, the accounts              differences between the subsidiary ledger and
               receivable control account in the            the general ledger.
               general ledger.
                                                            Fees earned and cash receipts or accounts
                                                            receivable could be understated because of
                                                            failure to record billings, cash receipts, or
                                                            write-offs accurately.

Chapter 11 - Accounts Receivable, Notes Receivable, and Revenue

11-44 SOLUTION: Martin Mfg. Co. (Estimated time: 30 minutes)

        The journal entry recording Martin's sale of land to Ardmore is not acceptable, for it fails to
        recognize the discount implicit in the transaction. The fair value of the note receivable from
        Ardmore is not $550,000; because Ardmore refused to pay more than $770,000 principal and
        interest. By acquiescing to an 8 percent interest rate, Martin's management tacitly
        acknowledged that the fair value of the land was less than the $550,000 face amount of the
        note. The auditors should propose the following adjusting entry as of March 31, 200X:

         Gain on Sale of Land                              50,000
         Loss on Sale of Land ($500,000 - $436,590)        63,410
           Discount on Note Receivable ($550,000-$436,590)                  113,410

        To correct entry recording sale of land to Ardmore Corp. Note receivable from
        Ardmore ($550,000) has a present value of $436,590 when its $770,000 maturity
        value is discounted at 12%; as a result a loss of $63,410 ($500,000 cost less
        $436,590 fair value of note) was realized on the sale.

11-45 SOLUTION: Lawrence Company (Estimated time: 40 minutes)

        (1)     (a)      Examine supporting documents, including the sales invoices and applicable
                         sales and shipping orders, for propriety of the account receivable.
                (b)      Review the cash receipts journal for the period after September 30, 200X, and
                         note any collections from Moss Company. The degree of internal control over
                         cash receipts should be an important consideration in determining the reliance
                         that can be placed on the cash receipts entries. In addition, as there is no
                         assurance that collections after September 30 represent the payment of
                         invoices supporting the September 30 account balance, consideration should
                         be given to requesting a confirmation from Moss Company of the invoices
                         paid by its checks.

        (2)     (a)      The exception should be investigated thoroughly. If the credit was posted to
                         the wrong account, it may indicate merely a clerical error. On the other had,
                         posting to the wrong account may indicate lapping. To assure that both
                         accounts have been properly stated, the account originally credited should be
                         reconfirmed unless the customer has already questioned the propriety of the
                (b)      Such a comment may also indicate a delay in recording and depositing of
                         receipts. If, upon investigation, such is the case, the company should be
                         informed so that they can take corrective steps.

        (3)     This is a confirmation of the balance with an additional comment. As the customer has
                given the data, it is preferable to see that the information agrees with the company's
                records. Such a procedure may disclose lapping, misposting, or delay in recording of

Chapter 11 - Accounts Receivable, Notes Receivable, and Revenue

        (4)     This incomplete comment should raise an immediate question: Does the customer
                mean paid before or paid after September 30? As it is unsafe to assume what the
                customer intended, this account should be reconfirmed and the customer asked to state
                the exact date. Upon receipt of the second confirmation, the information thereon
                should be traced to the cash receipts journal.

         (5)    A comment of this type indicates that the company may be recording sales before a sale
                has legally taken place. The auditors should examine the invoice and review with the
                appropriate officials the company's policy on shipment terms and determine if sales,
                cost of goods sold, inventories, and accounts receivable have to be adjusted. Follow-
                up for comparable cutoff problems should be made as of October 31, the balance sheet

        (6)     (a)      Determine if such advance payment has been received and that it has been
                         properly recorded. A review should be made of other advance payments to
                         ascertain that charges against such advances have been properly handled.
                (b)      If the advance payment was to cover these invoices, the auditors should
                         propose a reclassification of the $1,350, debiting the advance payment account
                         and crediting Accounts Receivable—Trade.

         (7)    (a)      Examine the shipping order for indications that the goods were shipped and, if
                         available, carrier's invoice and/or bill of lading for receipt of the goods.
                (b)      If it appears that goods were shipped, send all available information to the
                         customer company and ask it to reconfirm. If the customer still insists that
                         goods were never received, all data should be presented to an appropriate
                         company official for a complete explanation. This may indicate that
                         accounting for shipments is inadequate and consideration should be given to
                         reviewing the procedures to determine if improvements can be made.
                (c)      If the goods were not shipped, the auditors should recommend an adjustment
                         reducing sales, cost of goods sold, and accounts receivable, and increasing

         (8)    This should be discussed with the appropriate officials and correspondence with the
                customer reviewed and determination made if an adjustment should be made in the
                amount receivable, or if the allowance for doubtful accounts should be increased as of
                October 31.

         (9)    As title on any goods shipped on consignment does not pass until those goods are sold,
                the sales entry should be reversed, inventory charged, and Cost of Goods Sold credited.
                 Other so-called sales should be reviewed and company officials queried to determine
                if other sales actually represent consignment shipments.

        (10)    This is a noncurrent asset and should be reclassified to either deposits or prepaid rent.
                A review of other accounts, especially those with round figures, may disclose other
                accounts that should be so reclassified.

        (11)    This may indicate a misposting of the credit or a delay in posting the credit. Comments
                under (2) above would also apply to credits.

Chapter 11 - Accounts Receivable, Notes Receivable, and Revenue

11-46 SOLUTION: Hall Corporation (Estimated time: 20 minutes)

        The starting point for Chambers' examination of notes receivable was the obtaining of a list of
        notes receivable at December 31, prepared by the client. When the auditors make use of
        schedules prepared by the client, they must prove the accuracy and validity of such schedules
        by firsthand investigation. In this case, the auditor merely proved the footing of the list and
        compared the total with the general ledger control account and with the amount shown on the
        balance sheet. Apparently, he did not inspect the notes receivable themselves, or compare them
        with the list prepared by the client. Let us assume that Hall Corporation (or one of its officers
        or employees) had pledged the notes as collateral for a bank loan or had discounted the notes
        outright. The makers of the notes would not necessarily be aware of this action; therefore,
        Chambers' confirmation of the notes by direct communication with the makers would not
        disclose that the notes were missing.
               If Chambers had insisted on inspecting the notes, he might have been told that they had
        been pledged. In that case, he should have confirmed the existence and ownership of such
        notes by direct communication with the holders.
               The case as stated does not mention physical inspection of the notes by the auditor, but it
        does describe in detail the various auditing procedures which were employed. Since physical
        inspection of the notes was not mentioned, we may reasonably assume that this essential
        auditing procedure was omitted. All audit procedures employed and the results of such
        procedures should, of course, appear in the audit working papers.
               Under the circumstances, it appears that Chambers' audit of notes receivable did fail to
        meet minimum professional standards as charged in the suit filed by the creditors of Hall

11-47 SOLUTION: Marlborough Corporation (Estimated time: 30 minutes)

        (a)     Classifying the advance to Olds as a current asset is inappropriate. The date of
                repayment is not set, and it is doubtful that the funds will be available to meet
                obligations during the next operating cycle. Presentation as a current asset will mislead
                users of the financial statements; they may conclude that the company's current
                position is stronger than it is.
                       Financial presentation is not adequate unless all material matters are disclosed.
                Olds's contention that this would "just give the raiders ammunition" implies that
                additional disclosure is needed to make the financial statements complete.
                       Description of the advance as "miscellaneous accounts receivable" is inadequate.
                 Properly it should be shown as an advance (or loan) to a company officer. In view of
                the materiality of the advance, the note description should identify Olds and the nature
                of the collateral.
                       Under some circumstances Olds's acquisition of the stock might be considered
                as disguising the company's acquisition of treasury stock. Factors involved in this
                determination are the parties' intentions, Olds's fiscal capacity to acquire the stock, and
                the legal implications of the transactions.

Chapter 11 - Accounts Receivable, Notes Receivable, and Revenue

        (b)     The first three actions proposed by Olds are desirable, but they have limited usefulness
                and are not valid alternatives to further disclosure. Specific comments on each follow:

                (1)      The Board of Directors appears to be dominated by Olds, and its post-factum
                         approval will be perfunctory and lack independence.
                (2)      Execution of a demand note formalizes Olds's obligation, but it probably will
                         not improve collectibility. The date of repayment remains uncertain and the
                         demand designation does not justify classification as a current asset.
                (3)      Endorsement of the stock will help the company establish ownership, if that
                         should become a problem, but it appears that the collateral may be inadequate
                         (a)      The market price of the stock may have been artificially stimulated by
                                  the purchases of Olds and the raiders.
                         (b)      The prevailing market price often cannot be realized when large
                                  blocks of stock are sold.
                (4)      A written opinion from the company's attorney, will not eliminate the need for
                         further disclosure, but it is vital and should be obtained under any
                         circumstances. In particular, the attorney could be asked to consider whether
                         the stock transactions might be considered an acquisition of treasury stock, if
                         this would be a valid use of funds, and what Olds's voting rights would be in
                         this circumstance.

        (c)     If the CPA concludes that additional disclosure is essential to fair presentation of the
                financial statements and Marlborough refuses to disclose the additional information,
                the CPA should provide the necessary supplemental information in his report and
                express an adverse opinion, as the client's statements do not present fairly its financial
                position, results of operations, and cash flows in conformity with generally accepted
                accounting principles. If the client is unwilling to accept his report, the CPA's only
                alternative is to withdraw from the engagement.

        (d)     The effect of Olds's warning, if any, should be the opposite of his intention. The CPA
                must be especially careful and avoid any appearance of collusion with the client. If the
                raiders are successful, he probably will lose the audit engagement. He also can expect
                that the company's accounting and his past work will be carefully reviewed.
                Accordingly, he should evaluate his present actions in the light of how they must
                subsequently appear in a court of law. He probably should consult his own attorney
                concerning his risk and responsibilities.

11-48 SOLUTION: Granite Corporation (Estimated time: 15 minutes)

        (1)     A contingent liability of $50,000 exists with respect to the discounted 60-day note from
                the customer of unquestioned financial standing and this contingency should be
                disclosed by a note to the balance sheet.
        (2)     The contingent liability to the bank for the $60,000 note receivable discounted should
                be disclosed by a note to the financial statements. This disclosure should include a
                statement of the intention to make an advance of $80,000 to the affiliate from which
                the affiliate will make payment of the present note to the bank. The disclosure should
                also describe the relationship between the two companies.

Chapter 11 - Accounts Receivable, Notes Receivable, and Revenue

        (3)     The $20,000 note from the former executive appears to be worthless and the loss
                should be recognized and reflected in the financial statements. In this case, the liability
                to the bank is not really of a contingent nature since all available information indicates
                that Granite Corporation will have to make the payment. Consequently, a current
                liability should be included in the balance sheet to show the anticipated payment to the

11-49 SOLUTION: Aerospace Contractors, Inc. (Estimated time: 20 minutes)

        (a)                      AEROSPACE CONTRACTORS, INC.
                                      Partial Balance Sheet
                                         July 31, 200X

                Current Assets:
                   Accounts receivable:
                     Commercial, less allowance
                         for uncollectible accounts $75,000           $ 542,000
                   U.S. government, including $320,000
                         claims under terminated contracts             3,502,000
                Other Assets:
                   Due from Harwood Co., investee                        480,000

        (b)     The claims receivable from public carriers and the trade notes receivable are
                immaterial, and may be included with commercial accounts receivable. The allowance
                for doubtful accounts and notes relates to the commercial accounts and trade notes,
                since receivables from the U.S. government are collectible. Receivables from the U.S.
                government are of sufficient materiality to warrant presentation. Since the termination
                claims are different from the regular receivables and are themselves material, they
                should be disclosed.
                       The amount due from the investee should be shown separately because it is a
                related party receivable. It also may need to be classified as a noncurrent asset, since it
                may be collected at the convenience of the borrower.

In-Class Team Case

11-50 SOLUTION: Wellington Sales, Inc. (Estimated Time 30 Minutes)

        # 5     Zimber should determine that the check was deposited on December 28 by examining
                the supporting documentation (e.g., entry in cash receipts journal, deposit ticket, bank
                statement). He should also determine (1) that the error has been corrected, (2) why the
                account was recorded improperly, and (3) whether it is indicative of broader problem.
                This account should have had a balance of zero as of year-end.

        #22     Zimber should determine whether these goods were ever shipped, and if so, whether
                they have been returned. The existence (or nonexistence) of a shipping document will
                in this case provide a starting point for the analysis. It seems likely that the balance of
                the account should be zero, but, prior to performing the above procedures, this is

Chapter 11 - Accounts Receivable, Notes Receivable, and Revenue

        #47     Zimber should send a second request to The Big Edge. This second request should
                include individual invoice numbers and amounts. It might also be helpful to send
                copies of the invoices themselves. Another option here is to examine shipping
                documents and subsequent cash receipts. At this point, no evidence on the proper
                balance has been collected.

        #51     Zimber should determine whether (and when) the check was received and recorded in
                the cash receipts journal. If it was received after year-end, the account is a valid
                receivable as of December 31.

        #62     Zimber should determine Pibson Gonker Corporation's address. This may be available,
                for example, from the purchase order Pibson sent initiating the order. Zimber might
                wish to further examine the propriety of this address through various databases on the
                Internet. While the return of a confirmation request such as this might simply be due
                to misprocessing the address, it might also have resulted from the company going out
                of existence or never having existed in the first place. The proper balance is very much
                in question, although it may well be found to be proper.

        #68     Zimber should simply determine that the check was received early in January. The
                balance of $66,000 has been confirmed without exception.

        #72     While this receivable would seem to be confirmed without exception, the note might
                lead the auditors to an investigation of whether the right of return on these and other
                goods is typical for the industry and whether any sort of allowance for returns is

        # 77    Zimber should examine the terms of the documents supporting the transaction to
                determine whether this is a sale or a consignment. If it is a sale, it represents a
                receivable, although the customer's misunderstanding may cause the auditor to question
                whether an allowance for returns is necessary. If it is a consignment, the transaction
                should be recorded at cost with a debit to Consigned Inventory and a credit to
                Inventory--in such case the receivable is misstated.

        # 79    Zimber should consider the terms of shipment to determine whether a valid sale has
                occurred. For example, if goods were shipped "FOB shipping point" on December 31,
                or before, the receivable is properly recorded as of year end. If shipped "FOB
                destination" no sale should be recorded until the goods are received by the customer.
                Students will probably have learned about shipping terms in prior classes; the
                information is subsequently presented in this text in Chapter 13. The only real
                knowledge necessary is that for transactions such as this title ordinarily passes as
                         FOB shipping points--title ordinarily passes when the goods are shipped.
                         FOB destination--title ordinarily passes when the goods are received by

Chapter 11 - Accounts Receivable, Notes Receivable, and Revenue

Ethics Case

11-51 SOLUTION: Universal Air (Estimated time: 20 minutes)

        (a)     Issues related to each of the justifications include:

                    This explanation may be acceptable if the auditor has reasonable assurance that no
                     material misstatement is likely to exist. Any unrecorded liability relating to these
                     flights at year-end must be immaterial in order to justify the treatment.

                    While booking the sale may be critical, the service provided by this company is
                     transportation. Conceptually, the revenue should not be recognized before the

                    The difficulty of obtaining the information does not justify a departure from GAAP
                     that materially distorts results.

        (b)     While under circumstances of relatively small changes in sales one might expect an
                “averaging out” to occur, there seems to be no reason to expect this to be so when sales
                are up 30% as compared to the previous year. How significant the 30% change is
                depends upon the dollar amount of advance sales.

        (c)     To determine whether this averages out, one approach is to randomly select a sample of
                sales late in each year (depending upon how far in advance passengers typically book
                tickets) and attempt to determine whether they approximate one another. Also, an
                estimate might be based on number of reservations booked in the new year if it is
                possible to efficiently capture that information from the preceding year (which seems
                doubtful). Using that approach one still needs to make an estimate of revenues related
                to the bookings. Another approach that might or might not be possible, is to obtain
                assistance from the sales department (reservation department). For example, the sales
                department could have helpful reports that could help the accountant to make an
                estimate of sales for next year’s flight.

11-52 SOLUTION: Universal Air II          (Estimated time: 20 minutes)

        (a)     A significant deficiency is a deficiency that adversely affects the company’s ability to
                initiate, authorize, record, process, or report external data reliably in accordance with
                generally accepted accounting principles, such that there is more than a remote
                likelihood that a misstatement of the company’s financial statements which is more
                than inconsequential will not be prevented or detected. This does not appear to be a
                significant deficiency. If the auditor considers it a significant accounting policy it
                should be communicated to the audit committee.

        (b)     There is no requirement to report it elsewhere. It is doubtful that this policy is illegal.
                If material refunds are expected an allowance for sales returns type entry might be

Chapter 11 - Accounts Receivable, Notes Receivable, and Revenue

        (c)     The policy might cause one to question the integrity of the firm’s management. It also
                seems shortsighted as the airline’s success must in part be due to repeat customers.
                Future customer or press awareness of this policy is not likely to have a positive impact
                on sales.

                Other issues that might be addressed include:

        (1)     Discuss the somewhat incomplete nature of auditor responsibilities in a case such as
                this. The client’s policy does not seem ethical, and one might question what other
                similar policies exist.
        (2)     What response is appropriate if the accountant’s assistant, Jane McClain, believes that
                someone should be informed or, at a minimum, the financial statements should include
                a note regarding the policy. Arguments for such a note would be that it is a significant
                accounting policy or that a possible contingent liability exists. Both of these seem

        (3)     In recent years, auditors have increasingly attempted to provide value-added services to
                clients in addition to the audit itself. The problem described in this case is a flaw in the
                client’s business process and should be brought to the attention of management.


11-53 SOLUTION: Audit Simulation—Accounts Receivable (Estimated time: 30 minutes)

        (a)      (3)     Answer (3) is correct because SSC’s use of progress billing will reduce the risk
                         related to doubtful accounts since the company can stop shipping materials in
                         circumstances in which a customer has not paid.

        (b)      (1)     Answer (1) is correct because the simulation emphasizes the fact that sales are
                         dependent upon economic growth.

        (c)      (1)     Answer (1) is correct because the inability to pass on increases in costs will
                         decrease the gross margin as cost of goods sold as a percentage of sales will

        (d)      (4)     Answer (4) is correct because credit sales at year end will increase the
                         numerator and denominator of the ratio by the same amount, which decreases
                         the ratio. Any ratio greater than 1 to 1 will increase if the numerator and
                         denominator are both increased by the same amount. For example, start with
                         the ratio 4 to 3, which equals 1.333. If the numerator and denominator are
                         both increased by 1, one obtains 5 to 4, which equals 1.250.

        (e)      (2)     Answer (2) is correct because vouching sales recorded in January (performing
                         cutoff tests) will reveal whether December sales were recorded in the wrong

        (f)     (4)      Answer (4) is correct because a review of the aged trial balance for significant
                         past due accounts will provide evidence on how much is expected to be
                         realized on receivables.

Chapter 11 - Accounts Receivable, Notes Receivable, and Revenue

        (g)      (7)     Answer (7) is correct because a review financial statement drafts of financial
                         statements will help assure that presentation and disclosure of receivables is

        (h)      (3)     Answer (3) is correct because vouching year-end receivables will help
                         establish that the client has rights to the recorded receivables since documents
                         such as sales invoices will provide support for the sale.

        (i)     We will not provide a detailed memo here. Your memo should be well written, and
                well organized. Although you should not have provided a list such as we have
                provided below, your memo should include points such as the following:

                        The company has established an audit committee for the first time this year.
                        Name the members of the audit committee.
                        Madonna Sherwood, the CEO’s wife, is the chair of the audit committee.
                        With Ms. Sherwood as chair, the independence of the audit committee is very
                         much at issue.
                        You might also have indicated that the CPA firm should obtain additional
                         information about Cindy Stone and Kelly Higgins.
                        The overall lack of audit committee independence is often the case with small
                         companies such as SSC. Indeed, many small companies have no audit

(j)     The information required is in AU 330.34:

        34 For the purpose of this section, accounts receivable means—
        a. The entity's claims against customers that have arisen from the sale of goods or services
        in the normal course of business, and
        b. A financial institution's loans.
        Confirmation of accounts receivable is a generally accepted auditing procedure. As discussed
        in paragraph .06, it is generally presumed that evidence obtained from third parties will provide
        the auditor with higher-quality audit evidence than is typically available from within the entity.
        Thus, there is a presumption that the auditor will request the confirmation of accounts
        receivable during an audit unless one of the following is true:
         Accounts receivable are immaterial to the financial statements.
         The use of confirmations would be ineffective.
         The auditor's combined assessed level of inherent and control risk is low, and the
             assessed level, in conjunction with the evidence expected to be provided by analytical
             procedures or other substantive tests of details, is sufficient to reduce audit risk to an
             acceptably low level or the applicable financial statement assertions. In many situations,
             both confirmation of accounts receivable and other substantive tests of details are
             necessary to reduce audit risk to an acceptably low level for the applicable financial
             statement assertions.

Chapter 11 - Accounts Receivable, Notes Receivable, and Revenue

              Chapter 11 Appendices

Audit Case Exercises

11A-1 KCN Revenue Cycle Controls (Estimated time: 20 minutes)

        (a)        Sales controls:

                             Control                                      Error or Fraud Controlled
              1.      Application controls are applied when       Controls errors in the delivery and billing of
                      customer orders are entered by the          sales transactions.
                      sales order clerk.
              2.      The computer assigns numbers to sales       Controls the recording of sales to ensure
                      invoices when they are prepared.            completeness.
              3.      Monthly statements are mailed to            Controls the recording of fictitious sales and
                      customers.                                  inaccurate sales to customer accounts.

        (b)        Cash receipts controls

                      Internal Control Procedure                          Error or Fraud Controlled
              1.      Cash receipts are prelisted by the          Controls errors in the recording of cash and
                      receptionist.                               controls the abstraction of cash.
              2.      The accounting manager reconciles           Controls the embezzlement of cash receipts and
                      control totals generated by the accounts    errors in and incomplete postings to accounts
                      receivable computer program.                receivables records.
              3.      The computer summaries of cash              Controls the abstraction of cash and the
                      collections and cash sales are              incorrect recording of cash receipts and cash
                      reconciled to prelistings of cash           sales.
                      receipts and cash deposits by the
                      accounting manager.

11A-2 KCN Internal Control Weaknesses (Estimated time: 15 minutes)

        The first weakness is that sales invoices are prepared and mailed prior to delivery of goods.
        Errors may occur in that different quantities of goods may ultimately be delivered than have
        been ordered, or goods may not be delivered at all. A related problem, at year-end, is that sales
        may be recorded for goods not delivered until subsequent to year-end, thus overstating sales
        and accounts receivable for the year.

        The second weakness is that accounts receivable are not written-off on a regular basis. This
        may result in an inadequate Allowance for Doubtful Accounts, with an associated
        understatement of Bad Debt Expense. Also, if management is not monitoring receivables
        collections, the company may currently be selling goods on credit to uncreditworthy customers.

Chapter 11 - Accounts Receivable, Notes Receivable, and Revenue

11A-3 KCN Attributes Sampling (Estimated time: 35 minutes)

        (a)     Audit sampling for tests of controls can be used when performance of the internal
                control procedure leaves some evidence of performance, such as a completed
                document or the initials of the person performing the procedure. This evidence of
                performance allows the auditors to determine whether the control procedure was
                applied to each item included in the sample. In addition, sampling will only be used in
                circumstances in which (1) the auditors wish to assess control risk for an assertion
                below the maximum, and (2) the likely rate of deviation from the control is less than
                the tolerable deviation rate.

        (b)     The appropriate table for determining the required sample size is illustrated in Figure
                9-4. Using the row for a 1 percent expected deviation rate, and the column for a
                tolerable deviation rate of 15 percent, we find a required sample size of 30 items, with
                1 allowable deviation.

                                          Keystone Computers & Networks, Inc.
                                     Attributes Sampling Summary—Revenue Cycle
                                                  December 31, 20X5

Chapter 11 - Accounts Receivable, Notes Receivable, and Revenue

                  Objectives of test:        To test the operating effectiveness of the procedures for matching
                                             sales invoices with deliver receipts.

                                     Test                    Population                Size
                                     (1)                     Sales invoices            xxx

                  Sampling unit: Individual reports

                  Random selection procedure: Random number table

                  Risk of assessing control risk too low: 5%

                                                   Planning Parameters:                       Sample Results:

                                            Tolerable     Expected                    Number        Achieved
                                            Deviation     Deviation    Sample            of         Maximum
                                             Rate          Rate         Size         Deviations       Rate

              1. 1. Matching of
              2.    sales invoices           15%           1%           30
              3.    with delivery
              4.    receipts


Chapter 11 - Accounts Receivable, Notes Receivable, and Revenue

11B-1 SOLUTION: KCN Substantive Procedures Audit Program (Estimated time: 20 minutes)

         (a)    “KCN has engaged in a strategy to sell to customers with higher credit risk.” The
                implication of this risk is that the company may experience significant additional
                amounts of bad debt expense. The audit team addressed this risk primarily with the
                following steps:

                10. Review the adequacy of the allowance for uncollectible accounts by performing
                    following procedures:
                    (a) Review the aged trial balance of accounts receivable with the president.
                    (b) Review confirmation exceptions for indications of disputed amounts.
                    (c) Analyze and review trends in the following relationships:
                         (1) Accounts receivable to net sales.
                         (2) Allowance for bad debts to accounts receivable.
                         (3) Bad debt expense to net sales.

                13. Review credit memoranda for sales returns and allowances through the last day of
                     fieldwork to determine if an adjustment is needed to record the items as of year-
                14. (c) Compute the accounts receivable turnover.

         (b)    “The officers of the company receive significant bonuses based on quarterly results.”
                The implication of this risk is that management may be inclined to misstate quarterly
                results to maximize bonuses. The audit team addressed this risk primarily with the
                following steps:

                    The confirmation procedures for accounts receivable, which include steps 2., 4., 5.,
                     6., and 7.
                    Review credit files and investigate any indications of fictitious accounts, step 8.
                    The cut-off procedures for sales, steps 11., 12., and 13.
                    The analytical procedures in step 14., especially the sales by month by salesperson.

11B-2 (a)       Examining the sales by month schedule provides an indication that management may
                be overstating revenue to meet quarterly and annual sales budgets. From the schedule,
                we see a pattern of increases in sales in the months of March, June, September, and
                December, with respect to computer sales. Also, note that the amount of sales tends to
                fall off in the month following the end of the quarter. This pattern is even more
                pronounced with respect to consulting revenue. The pattern is illustrated more
                dramatically with the following two tables. Schedule I presents monthly sales amounts
                as a percentage of total sales for the year, and Schedule II presents changes in monthly
                sales from the same quarter in the previous year.

Chapter 11 - Accounts Receivable, Notes Receivable, and Revenue

                                             Schedule I
                                  Keystone Computers & Networks
                                    Monthly Sales (Percentages)
                                   For the Year Ended 12/31/20X5

                                     Sales of            Consulting       Service
                                    Computers             Revenue         Revenue
                                      20X5                  20X5           20X5
              January                 7.72%                 6.96%          7.11%
              February                8.49%                 7.29%          8.06%
              March                   8.93%                 8.26%          8.06%
              April                   7.50%                 7.45%          9.00%
              May                     7.94%                 7.69%          8.06%
              June                    8.80%                 8.99%          8.53%
              July                    7.84%                 7.77%          8.53%
              August                  8.43%                 8.26%          8.06%
              September               9.18%                 9.39%          9.00%
              October                 7.46%                 8.50%          8.53%
              November                8.36%                 9.15%          8.53%
              December                9.36%                10.28%          8.53%
              Total                 100.00%               100.00%        100.00%

                                           Schedule II
                                Keystone Computers & Networks
                     Changes in Sales from the Same Month in the Prior Year

                        Sales of Computers          Consulting Revenue        Service Revenue
                         20X4         20X5            20X4        20X5       20X4         20X5
  January              19.42%       11.84%          19.05%      14.67%     16.67%        7.14%
  February             26.10%       15.86%           4.17%      20.00%     23.08%        6.25%
  March                18.51%       19.03%          22.39%      24.39%     15.38%       13.33%
  April                11.74%        3.96%          22.73%      13.58%     33.33%       18.75%
  May                   9.43%       10.26%          16.18%      20.25%      7.14%       13.33%
  June                 16.44%       16.86%          27.27%      32.14%     30.77%        5.88%
  July                  3.08%       13.39%           8.22%      21.52%     14.29%       12.50%
  August               11.05%       13.53%          26.09%      17.24%     15.38%       13.33%
  September            18.81%       16.21%          23.53%      38.10%     23.08%       18.75%
  October               8.99%       -0.79%          16.00%      20.69%      6.67%       12.50%
  November              5.45%        9.69%          24.66%      24.18%     14.29%       12.50%
  December             10.18%       17.12%          27.78%      38.04%      7.14%       20.00%
      Total            12.94%       12.31%          19.71%      24.00%     16.88%       12.83%

Chapter 11 - Accounts Receivable, Notes Receivable, and Revenue

    (b)         The procedures that would address the risk of management overstatement of revenue in
                the existing audit program include:

                1.       Confirm a sample of customer’s accounts at 12/31/X5.
                2.       Review the aged trial balance of accounts receivable with the president.
                3.       For all sales recorded in the last week of the year inspect the related delivery
                         receipt to determine the sale occurred before 12/31/X5.
                4.       Review credit memoranda for sales returns and allowances through the last day
                         of fieldwork to determine if an adjustment is needed to record the items as of

    (c)         Other procedures that might address the risk of management overstatement of revenue
                include (only two required):

                (1)      Review contracts for consulting jobs performed during the period and examine
                         time records or other records that serve as a basis for billings. Ascertain that
                         actual billings agree to these records.
                (2)      Consider confirming consulting contract terms with customers and progress on
                         existing contracts.
                (3)      Make inquiries of salesmen regarding modifications to typical sales terms, e.g.,
                         right to return goods for an extended period of time.
                (4)      Review sales recorded near the end of each quarter and inspect the related
                         delivery receipts.

Chapter 11 - Accounts Receivable, Notes Receivable, and Revenue

11B-3 SOLUTION: KCN Sampling Results (Estimated time: 35 minutes)

        (a)     Analysis of exceptions

                       Book           Audited      Mistate-
                       Value           Value        ment                              Explanation

                1.       $1,200        $1,200      -----                    The book value is correct because the
                                                                            cash receipt was not received by
                                                                            KCN prior to year-end.

                2.      $30,000       $29,670      $330                     The return should have been dated as
                                                                            of December 31.

                3.        $300          $300           -----                The balance is correct because the
                                                                            payment was made and received after

                4.    $13,000         $12,000      $1,000                   Because a portion of the delivery was
                                                                            subsequent to year-end, it should not
                                                                            be recorded until 20X6.

                5       $1800          $1,746          $54                  Because only $1,746 will be
                                                                            received, the adjustment should be
                                                                            made in the period the sale is

        (b)     (1)      Projected misstatement

                        Book          Audited     Misstate-            Sampling                    Projected
                        Value         Value       ment      Tainting %   Interval                 Misstatement

                        $30,000 $29,670           $ 330              NA                 NA            $ 330
                         13,000  12,000            1,000             7.7%             16,000          1,232
                           1,800  1,746               54             3.0%             16,000            480

                (2)   Basic precision = Reliability factor x Sampling interval

                                                   1.39        x     $ 16,000     =                 $22,240

                (3)   Incremental allowance

                          Reliability                                              Projected Incremental
                             Factor         Increment              (Increment-1) Misstatement Allowance

                               2.70             1.31                  .31                 1,232         382
                               3.93             1.23                  .23                   480         110
                                                                                                      $ 492

Chapter 11 - Accounts Receivable, Notes Receivable, and Revenue

                (4)      Upper limit on misstatement = $ 2,042 + $22,240 + $492 = $24,774

                       Since the upper limit on misstatement is less than the tolerable misstatement
                       ($35,000), the results indicate that the clients' book balance of accounts
                       receivable is not materially misstated.